Monday, February 24, 2014

What's safer: Individual bonds or funds?

A common misconception is that bond funds are more exposed to interest-rate risk than laddered individual bond portfolios. The truth is that they have identical exposure.

The logic for the standard view basically starts and ends with the observation that an investor can hold individual bonds to maturity while bond funds don't necessarily hold all bonds until they mature. Most bond fund managers trade their assets periodically.

Because you can hold individual bonds until they come due, as the conventional logic goes, it doesn't matter if their prices go up or down in the interim. But if you compare laddered individual bond portfolios and bond funds with similar-maturity holdings, you run virtually the same risk if rates change. Yet the incorrect viewpoint is all too common and can lead investors to take excessive interest rate risk in individual bond portfolios without understanding the implications.

When interest rates change, so does the price of your bond. Bond prices and rates move inversely. The great fear of bond investors is that rates go up and the value of their portfolio diminishes. If they sell their old bonds to buy higher-yielding paper, they take a loss.

For that reason, many smart investors construct a bond ladder. This is a collection of bonds that mature at regular intervals, so when one portion matures, you can invest it easily in issues paying higher rates.

To illustrate my point, I compare the returns and volatility of a laddered bond portfolio with a hypothetical bond fund portfolio. My laddered bond portfolio allocates equal investment dollars to bonds maturing from one through 10 years. At the end of each year, the portfolio effectively invests the proceeds from the one-year bond that matured into a 10-year bond and repeats this process each and every year. This is a good proxy for how bond ladders are actually constructed in practice.

Separately, I construct a bond fund portfolio using three-, five- and 10-year bonds, with this portfolio construc! ted to match the duration and convexity of my laddered bond portfolio. Duration and convexity are the two primary measures of the interest rate risk in a fixed-income portfolio. Duration gauges the sensitivity of a bond to rate moves; the higher a bond's duration, the more rate shifts affect its price. Convexity measures how duration changes as rates do.

Each year, my bond fund portfolio reallocates among its three choices to match the duration and convexity of the laddered bond portfolio. Note that none of the positions in this second portfolio ever mature.

If laddered bonds are truly safer than bond funds, these two portfolios should have significantly different risk-adjusted returns. I calculated the average annual returns and volatility – quantified by a number called standard deviation – of both portfolios from 1993 through 2013.

The average returns for the laddered bond and bond fund portfolios are 6.4% and 6.5% respectively. The average volatility is 6.5% for both portfolios. This is the longest data set available.

As the data show, the returns and volatility are virtually identical. At the end of the day, that's basically all that matters.

Note, however, that individual bonds can still have advantages relative to bond funds. It's just that those potential advantages have nothing to do with individual bond portfolios having less interest rate risk than bond funds. I covered the potential advantages and considerations in a previous article.

For both the bond ladder portfolio and the hypothetical bond fund portfolio, I used Barclay's Capital Interest Rate Swap Index series. These are zero-coupon securities that are very analogous to zero-coupon Treasury bonds. The reason I like to use this data is that this is a very liquid fixed income market and data are available for maturities ranging from one-year to 30-year securities in one-year increments.

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Jared Kizer is the director of investment strategy for The Bam Alliance and is a member of the AdviceIQ Adviser Network, which is a USA TODAY content partner offering financial news and commentary. Its content is produced independently of USA TODAY.